Why you shouldn’t expect profit margins to fall when prices rise

Recently, several progressive U.S. senators from New England have parroted the talking point that “Big Oil” is to blame for spiking gas prices. Sen. Elizabeth Warren (D-Mass.), for example, tweeted: “One of the reasons why prices are rising and consumers are paying more? Large corporations are using inflation as a cover to expand their profits. We need to lower costs for Americans by cracking down on corporate price gouging and creating more competition.” Her colleague, Sen. Ed Markey (D-Mass.) echoed these sentiments, as did Sen. Bernie Sanders (I-Vt.), who recounted oil profit figures and called it “unacceptable.”

These talking points have two main components: the backward-looking blame (that oil companies are responsible for higher costs) and the forward-looking proposals (taxing windfall profits, “cracking down on corporate price gouging,” and “creating more competition”). 

Reason magazine has explained how a windfall tax on oil profits — a Jimmy Carter solution to a 1970s problem — didn’t work the first time and should be expected to fail again. But it’s worth looking at the basic economics underlying the situation to understand why profit margins are rising with prices, rather than falling in a compensatory manner.

So, as Sen. Warren said to Andrea Mitchell recently, “Look, we get it — ‘supply and demand’ — that prices go up, but profit margins should not go up — that’s just oil companies gouging, when they do that.” This is the heart of the politicians’ grievance: If consumers are hurting, why should producers be making more money? But the argument doesn’t make sense. 

The key here is profit. As Thomas Sowell wrote in “Basic Economics”: “Highly educated and highly intellectual people like George Bernard Shaw, Karl Marx, [Indian Prime Minister] Jawaharlal Nehru and John Dewey … have misconceived profits as arbitrary charges added on to the inherent costs of producing goods and services,” labeling profits things such as “surplus value” and “overcharge.”

Profits play two important roles. First, they act as incentives for businesses to produce desirable goods and services. This is the aspect of them with which everyone is probably familiar, even if they find it unsavory. But profits also play a role on the demand side of things. When people try buying more of a thing, that leads to a rise in prices. Higher prices that aren’t driven by higher costs on the supply side mean bigger profit margins. 

And it’s important for markets to allow this — especially in times of crisis. Sowell provides the example of homes being lost to a flood or fire. The demand for local hotel rooms would shoot up. “When the local population wants more hotel rooms than there are available locally,” he points out, “these rooms will have to be rationed, one way or another.” If government actors, incensed by profit margins, declare it illegal for hotels to respond to the increased demand with higher prices, the supply of hotel rooms will be consumed by those who arrive first. But if prices are allowed to respond to the increased demand, people have reason to self-ration: extended families, or families with many children, who ordinarily might book multiple rooms, would be incentivized to confine themselves just to one, opening another room up for someone else.

In the case of gasoline, where hoarding is a possibility, this can be even more crucial. The 1970s once again are instructive. Sowell recounts how “during the gasoline shortages of the 1970s, motorists were less likely to let their gas tanks get down as low as usual before going to a filling station to buy more gas. Some motorists with their tanks half-full would drive into any filling station that happened to have gas, and fill up the other half, as a precaution.” This is essentially the kind of panic buying and hoarding that led to toilet paper shortages at the start of the pandemic in April 2020.

This applies whether prices are kept down from price controls directly, or by taxing “windfall profits,” as Sen. Warren proposes. Instituting a tax on windfall profits just signals to companies that the next time shortages drive their prices up, they have that much less of an incentive to be prepared to meet demand. 

This is worth keeping in mind since Democrats keep applying this poor reasoning to different goods and services. Last December, the White House published a blog post entitled, “Recent Data Show Dominant Meat Processing Companies Are Taking Advantage of Market Power to Raise Prices and Grow Profit Margins.” In January, the New York Times reported that “Democrats Blast Corporate Profits as Inflation Surges,” highlighting comments from Sen. Warren, Sen. Sherrod Brown (D-Ohio) and White House Press Secretary Jen Psaki. 

But this outrage stems from a blind spot: When demand for a good rises, prices will rise consequently. That means rising profit margins, and that’s not a bad thing. Prices rising responsively are good for consumers — improving their chance at paying some price for a good, though high, for what they want, rather than being unable to find it anywhere.

Noah Diekemper is the senior research analyst at the Wisconsin Institute for Law & Liberty, a free-market policy organization. Follow him on Twitter @NoahDiekemper.